Lecture Notes - ECON 22358G - Chapter 10 - Part II - No Answers

CHAPTER 10
ECONOMIC FLUCTUATIONS – PART II

EQUILIBRIUM IN THE ECONOMY (A) 2
• So far, we have looked at AD and AS separately.
• Let’s combine them into a model of AD and AS.
• Similar to the market for an individual product, the forces underlying AD and AS
push the economy to an equilibrium point at the intersection of the AD and AS
curves:
Why?
– A price level above equilibrium means an unintended increase in inventories (or

positive unplanned investment), lowering the price level towards equilibrium.
– A price level below equilibrium leads to an unintended decrease in inventories (or

negative unplanned investment), raising the price level towards equilibrium.
ECON22358G - Macroeconomics
FIGURE 10.9: AN ECONOMY AT EQUILIBRIUM
Aggregate Demand and Supply Curves
3
Aggregate Demand and
200 AS
Supply Schedules
Price Level (GDP deflator,

a a Positive
AS – AD 160 Unplanned
(surplus (+) or
2007 = 100)
b Investment
shortage (-)) 120
Price Level (2007 $ billions) c c
AD
80
200 (725 – 650) = +75 Negative
Unplanned
(700 – 700) = 0 40
160 Investment
120 (650 – 750) = -100
0 650 700 750 800
Real GDP (2007 $ billions)
• If the price level, at points a, is above its equilibrium level, real output exceeds expenditures.
• An unintended rise in inventories causes businesses to lower prices until output and expenditures are the
same (point b).
• When the price level is below its equilibrium value (points c), there is an unintended fall in inventories.
• Businesses increase prices until equilibrium is reached (point b).
EQUILIBRIUM IN THE ECONOMY 4
• The tendency to move toward equilibrium can be understood by looking at the

flows of income payments and purchases that connect resource and product
markets.
• Injections: add to the main income-spending stream in any economy:
– Investment (I), Government purchases (G), and Exports (X).
• Withdrawals: divert funds from the income-spending stream in any economy:
– Saving (S), Taxes (T), and Imports (M).
INJECTIONS WITHDRAWALS
1. Investment (I) 1.Savings (S)
RECALL: CIRCULAR FLOW
2. Gov’t Purchases (G) 2.Imports (M) 5
3. Exports (X) 3.Taxes (T)
Income Resource Income

Markets
Investment (I) Financial Saving (S)

Intermediaries
Taxes (net of subsidies)

Businesses Government Taxes (net of transfers) Households
Gov’t Purchases (G)
Rest of the
Export (X) World Imports (M)
Spending
Product
Consumption (C)
Markets
• An economy’s equilibrium occurs at a point where:
Injections (I+G+X) = Withdrawals (S+T+M).
• When total injections exceed total withdrawals then real output and
spending expand until a new balance is achieved.
• When total withdrawals exceed total injections then real output and
spending contract until a new balance is achieved.
WITHDRAWALS
1. Savings (S)
2. Imports (M)
I+G+X
I+G+X=>S+M+T
S+M+T
3. Taxes (T)
Economy
Economy
Economy
is in equilibrium
Shrinks
Grows
INJECTIONS
1. Investment (I)
2. Gov’t Purchases (G)
3. Exports (X)
• When injections (I+G+X) = withdrawals (S+M+T) then the circular flow is in balance.
• If I+G+X > S+M+T, then the level of national income will rise
• If I+G+X < S+M+T, then the level of national income will contract
FIGURE 10.10: AN ECONOMY AT ITS POTENTIAL 8
OUTPUT
240 AS

200
160
2007 = 100)
120
80
Potential AD
40 Output
0 725
• It is possible for equilibrium to occur at the economy's potential output.
• In this case, actual unemployment equals the natural unemployment rate.
RECESSIONARY AND INFLATIONARY GAPS 9
• A Recessionary Gap:
– occurs during a contraction when equilibrium output falls short of
potential output, and is associated with an unemployment rate
above the natural rate
• An Inflationary Gap:
– occurs during an expansion when equilibrium output exceeds
potential output, and is associated with an unemployment rate
below the natural rate as well as increased pressure on prices
FIGURE 10.14: EXPANSION AND CONTRACTION
Potential 10
Output AS
240 f
e
2007 = 100)
160 AD0
Inflationary
Gap
Recessionary
Gap
AD1
0 700 725 730

• Periods of contraction lead to a decrease in aggregate demand, shifting the curve from AD 0 to AD1.
• This leads to a fall in equilibrium output from $730 to $700 billion (points f to e).
• As a result, the initial inflationary gap of $5 billion turns into a recessionary gap of $25 billion.
• Periods of expansion reverse the change, causing the curve to shift from AD 0 to AD1 and increasing
equilibrium output (points e to f).
FIGURE 10.15: RECESSIONARY AND INFLATIONARY GAPS
AS
11
Potential
Output
240 240
AS

Inflationary
200 200
Gap AD
2007 = 100)
2007 = 100)
160 160
120 120
Recessionary
80 80
Gap
Potential
40 40
Output
AD
0 700 725 0 725 730
Real GDP (2007 $ billions) Real GDP (2007 $ billions)
Recessionary Gap Inflationary Gap
• When real output falls short of potential output, the difference between the two is a recessionary gap,
as shown on the left.
• In contrast, when real output temporarily exceeds its potential level, the difference between the two is
an inflationary gap, as shown on the right.
ACTIVE LEARNING 12
Which graph illustrates a recessionary gap?

A) A
B) B
C) C
D) D
Which graph illustrates an inflationary gap?

A) A
B) B
C) C
D) D
ACTIVE LEARNING 13
Which graph is associated with positive

unplanned investment?
A) A
B) B
C) C
D) D
Which graph shows an economy with
unemployment at the natural rate?
A) A
B) B
C) C
D) D
ACTIVE LEARNING 14
What is the equilibrium level of prices?
A) 200.
B) 180.
C) 210.
D) 220.
E) 190.
Which of the following would be true if the
price level were 190?
A) Prices would fall.
B) A shortage of goods and services of 200.
C) Aggregate supply will rise.
D) A surplus of goods and services of 200.
E) Equilibrium exists.
ECONOMIC GROWTH 15
• Economic growth is an increase in the total output of goods and services.
• It can be defined in two ways:
– The percentage increase in real GDP.
– Most appropriate when measuring an economy’s overall productive

capacity.
– The percentage increase in per capita real GDP
– Most appropriate when measuring living standards.
ECONOMIC GROWTH 16
• An Example:
– Canada's real GDP, valued in 2007 dollars, was:
– $1661.559 billion in 2012.
– $1694.941 billion in 2013.
– During the same period, population expanded from 34,754.3 to 35,158.3 million.
(1694.941− 1661.559)
% ∆ 𝑹𝒆𝒂𝒍 𝑮𝑫𝑷 = ×100=𝟐 . 𝟎 %
1661.559
1694.941 1661.559
( − )
35,158.3 34 754.3
% ∆ 𝑹𝒆𝒂𝒍 𝑮𝑫𝑷 𝒑𝒆𝒓 𝒄𝒂𝒑𝒊𝒕𝒂= ×100=𝟎 . 𝟖 %
1661.559
34 754.3
ECONOMIC GROWTH 17
• Economic growth is often illustrated with the use of the production

possibilities curve (PPC) in two ways:
1. An outward shift in the PPC due to technological change or an

increase in economic resources.
2. A movement towards the boundary of the curve because in the case

where not all resources have been employed or used to their fullest
capacity.
FIGURE 10.12: THE PROCESS OF ECONOMIC GROWTH 18
PPC1
Hamburgers
PPC0
a
40
0 1 2
Robots
• Initially, the economy is on PPC0 and chooses to produce at point a.
• Only by increasing economic resources and/or improving their productivity can the economy grow.
• By doing so, the economy can expand the production possibilities from PPC0 to PPC1.
FIGURE 10.12: THE PROCESS OF ECONOMIC GROWTH 19
PPC1
PPC0
0 1 2
• Initially, the economy is on PPC0 and chooses to produce at point a.
• Only by increasing economic resources and/or improving their productivity can the economy grow.
• By doing so, the economy can expand the production possibilities from PPC0 to PPC1.
FIGURE 10.16:
PRODUCTION OPTIONS AND THEIR IMPACT 20
Country A Country B
250 b
d
Hamburgers
Hamburgers
200
c
PPCA 100 PPCB
40
a
PPC PPC
0 1 2 0 1 2
Robots Robots
• Countries A and B have the same initial PPC. However, A chooses point a on the left and B chooses point c on the right.
• Because A puts more resources into the capital good (robots) than B, which puts more into consumer goods (hamburgers),
Country A encourages greater growth.
• Within the same time period, A's PPC expands to PPC A so that it may choose point b. Country B's production possibilities
expand less so, to PPCB, so that it may choose point d.
THE RULE OF 72 21
• THE RULE OF 72:
– Shows the effects of exponential growth
– States that the number of years it takes a variable to double can be estimated
by dividing 72 by the variable’s annual percentage change
Rule of 72
– Suppose you have money invested and it receives an annual 5% return.

72
= 14.4.
5
FIGURE 10.17: GDP AND GROWTH RATES
22
After only 10 years, the

difference between Country X's
and Country Y's outputs is over
$20 billion.
• Two countries, X and Y, have the same GDP in Year 1, but different growth rates.
• Because growth is exponential, Country X's GDP falls behind Country Y's by an increasing margin.
• For example, Country X's GDP rises from $100 billion to $102 billion (= $100 billion × 0.02) in Year 2.
• Meanwhile, Country Y's rises from $100 billion to $104 billion (= $100 billion × 0.04).
ACTIVE LEARNING 23
• Calculate the following values using the rule of 72:
a) The number of years it will take a country's population to double if the annual
growth rate is 0.5 percent
b) The average annual rate of growth in per capita real GDP, if it takes this variable 27
years to double
c) The approximate number of times a country's capital stock will double in 24 years if
the annual growth rate in the capital stock is 6 percent
SOURCES OF ECONOMIC GROWTH 24
• The main causes of growth in total real output are the stock
of economic resources and how productively these
resources are used.
• A main cause of growth in Canada’s real output is the

increase in the quantity of labour.
– Accounting for an estimated 35 percent of the growth in Canada's
real GDP in the last two decades of the twentieth century
• It’s not just the quantity of labour that is important, it’s also:
Labour Productivity
= Output per worker per hour
“Labour productivity is probably the most telling measure of

economic performance. Unless productivity grows, living
standards stagnate.”
The Economist
• Labour productivity is directly linked to improved standards of living.
• As labour productivity grows, more goods and services can be produced for the
same amount of human effort.
LABOUR PRODUCTIVITY 26
• Example:
– Consider a hypothetical economy with 5 workers employed for 2,000 hours annually.
– Thus, the economy uses 10,000 hours of labour per year (= 5 × 2000).
– If real GDP in the economy is $200,000:
– Labour Productivity = $20 (= $200 000 ÷ 10 000):
– If real GDP rises to $202,000 in the following year and labour hours remain constant:
– The new level of labour productivity is $20.20 (= $202 000 ÷ 10 000)
– Which would mean an increase of 1% [(= $20.20 – $20.00) ÷ 20) × 100%].
• The main factors of economic growth are:
– The quantity of capital
– Technological progress The better an economy
– The quantity & skills of labour scores on these factors,

the higher will be its
– Efficiency in production
productivity and
– The quantity of natural resources
living standards
– Social and political factors
LABOUR PRODUCTIVITY IN SELECTED COUNTRIES
28
• Canada's average annual growth in labour productivity between 2000 and 2020 and 2012, at 1.35 percent, was
greater than the other industrialized countries, except for Korea and United States.
FIGURE 10.16: R&D SPENDING IN SELECTED
COUNTRIES 29
R&D spending as a percentage of GDP varies widely for these selected countries, as does the number of researchers per
1000 employed in each country.
ACTIVE LEARNING 30
Consider an island economy with 15 people of working age, 10 of which are

presently working, and each produces 10 units of real output per day.
(a) the real GDP of the island economy is ________ units per day.
If the islanders want to increase their real GDP to 150 units per day, the two basic
approaches to doing this would be to:
(b) ______________________________________________________________
_
(c) _______________________________________________________________
THE ADVANTAGES AND DISADVANTAGES OF 31
GROWTH
Advantages Disadvantages
Advantages Disadvantages
• Opportunity cost in terms of

• Positive effect on living standards
• Positive effect on living standards sacrificed current consumption
• Possible effect on social

• Possible effect on social • Environmental costs
improvements
improvements
• Social costs
• Psychological benefits
ACTIVE LEARNING 32
• Identify how each of the following will tend to move during:

Economic Economic
Expansions Contractions
a) Consumption of durable goods
Since the consumption of durable goods depends on households' disposable income it moves
down during contractions and up during expansions.
b) Planned investment
Recall that planned investment depends on business expectations which tend to be optimistic
when output is rising and pessimistic when real output is falling. Therefore planned investment tends
to fall during contractions and rise during expansions.
ACTIVE LEARNING 33
Economic Economic
c) Exports
Exports depend on foreign incomes. Given that business cycles in various countries tend to move together,
exports usually fall during contractions and rise during expansions.
d) Wage rates
The demand for labour tends to move in the same direction as real output. Therefore wage rates tend to be
pushed down during contractions and pushed up during expansions.
ACTIVE LEARNING 34
Economic Economic
e) Unplanned investment
Equilibrium output tends to move down during contractions, which are associated
with positive unplanned investment, and up during expansions, which are associated with
negative unplanned investment.
BUSINESS CYCLES 35
• The business cycle is the cycle of expansions and contractions in an
economy.
– An expansion is a sustained rise in real output.
– A peak is the point in the business cycle at which real output is at its
highest.
– A contraction is a sustained fall in real output.
– A trough is the point in the business cycle at which real output is at its
lowest.
CONTRACTIONS 36
• A contraction:
– is usually caused by a decrease in AD magnified by the reactions of

both households and businesses, who spend less due to pessimism
about the future
– may be a recession, which is a decline in real output for six months or

more
– may be a depression, which is a particularly long and harsh period of

reduced real output
EXPANSIONS 37
• The spiral of worsening expectations and declining real output

does not last indefinitely.
• Sooner or later, the economy reaches a trough, where real output

is at its lowest possible value in the business cycle
• An expansion is usually caused by an increase in AD magnified

by the reactions of both households and businesses as they spend
more due to more optimistic expectations of the future.
FIGURE 10.13: THE BUSINESS CYCLE 38
CONTRACTION EXPANSION
Real GDP
Long-Run Trend
of Potential Output
Peak
a c
Inflationary gap Recessionary gap
b d
Trough
Time
• Real GDP rises and falls in a cycle of expansion and contraction.

• These fluctuations can be compared with a trend line that represents long-run growth potential.
• The distance between actual output and the trend line represents the size of either the economy's inflationary
gap (as in the case of points a and b) or the economy's recessionary gap (as in the case of points c and d).
39
FLEX YOUR BRAIN
ACTIVE LEARNING 40
• Describe the situation in an economy during a recession.
ACTIVE LEARNING 41
• What causes changes in consumer and business confidence and why is confidence
important?
ACTIVE LEARNING 42
• What is the key factor that will increase human capital?
• An economy starts off with a per capita GDP of 16,000 euros. How large will the per capita
GDP be if it grows at an annual rate of:
(i) 3% for 10 years? (ii) 3% for 30 years? (iii) 6% for 30 years?
ACTIVE LEARNING 43
• Suppose the average worker in Canada has productivity of $33 per hour while the average
worker in the United Kingdom has productivity of $29 per hour (both measured in U.S.
dollars).
• Over the next six years, worker productivity in Canada grows at 1% per year while worker
productivity in the UK grows 3% per year.
• At that point, who will have the higher productivity level, and by how much?
ACTIVE LEARNING 44
• Some low-income countries and middle-income countries around the world have shown a
pattern of economic convergence with high-income countries. How is this possible?
ACTIVE LEARNING 45
Even in a market based economy there are some important roles for government in aiding a country's
economic growth. What are significant contributions a government can make toward a country's
economic growth?
ACTIVE LEARNING 46
• What are the main sources for economic growth in any economy?
TO DO LIST 47
• Read Chapter 10 in the textbook
• Complete Practice Problems: 10.2-10.5.
• Complete End-of-Chapter: Problems 4-12.
• Complete Self-Assessment Exercises in SLATE.

Lecture Notes - ECON 22358G - Chapter 10 - Part II - No Answers

Uploaded by

Document Information

Original Description:

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Lecture Notes - ECON 22358G - Chapter 10 - Part II - No Answers

Uploaded by

Copyright:

Available Formats

CHAPTER 10

ECONOMIC FLUCTUATIONS – PART II

• Let’s combine them into a model of AD and AS.

– A price level above equilibrium means an unintended increase in inventories (or

– A price level below equilibrium leads to an unintended decrease in inventories (or

Price Level (GDP deflator,

• The tendency to move toward equilibrium can be understood by looking at the

• Injections: add to the main income-spending stream in any economy:

– Investment (I), Government purchases (G), and Exports (X).

• Withdrawals: divert funds from the income-spending stream in any economy:

– Saving (S), Taxes (T), and Imports (M).

Income Resource Income

Investment (I) Financial Saving (S)

Taxes (net of subsidies)

• An economy’s equilibrium occurs at a point where:

Injections (I+G+X) = Withdrawals (S+T+M).

Price Level (GDP deflator,

• It is possible for equilibrium to occur at the economy's potential output.

• In this case, actual unemployment equals the natural unemployment rate.

0 700 725 730

Price Level (GDP deflator,

Which graph illustrates a recessionary gap?

Which graph illustrates an inflationary gap?

Which graph is associated with positive

• Economic growth is an increase in the total output of goods and services.

• It can be defined in two ways:

– The percentage increase in real GDP.

– Most appropriate when measuring an economy’s overall productive

– The percentage increase in per capita real GDP

– Most appropriate when measuring living standards.

– Canada's real GDP, valued in 2007 dollars, was:

– $1661.559 billion in 2012.

– $1694.941 billion in 2013.

• Economic growth is often illustrated with the use of the production

1. An outward shift in the PPC due to technological change or an

2. A movement towards the boundary of the curve because in the case

• Initially, the economy is on PPC0 and chooses to produce at point a.

• Initially, the economy is on PPC0 and chooses to produce at point a.

expand less so, to PPCB, so that it may choose point d.

– Shows the effects of exponential growth

– Suppose you have money invested and it receives an annual 5% return.

After only 10 years, the

• A main cause of growth in Canada’s real output is the

“Labour productivity is probably the most telling measure of

• Labour productivity is directly linked to improved standards of living.

– If real GDP in the economy is $200,000:

– Labour Productivity = $20 (= $200 000 ÷ 10 000):

– The new level of labour productivity is $20.20 (= $202 000 ÷ 10 000)

– Which would mean an increase of 1% [(= $20.20 – $20.00) ÷ 20) × 100%].

– The quantity of capital

– Technological progress The better an economy

– The quantity & skills of labour scores on these factors,

Consider an island economy with 15 people of working age, 10 of which are

• Opportunity cost in terms of

• Possible effect on social

• Identify how each of the following will tend to move during:

• Identify how each of the following will tend to move during:

• Identify how each of the following will tend to move during:

– An expansion is a sustained rise in real output.

– A contraction is a sustained fall in real output.

– is usually caused by a decrease in AD magnified by the reactions of

– may be a recession, which is a decline in real output for six months or